12. Advanced Currency Risk Management Flashcards
(44 cards)
Wha is money market hedging?
Taking the exchange rate NOW even though the payment is in the future by borrowing and lending on money markets and using the spot FX rate
What are the 5 steps in order to hedge future payments in $?
- Borrow in £ now
- Convert to $ at spot
- Deposit $ in a US bank, earning interest
- Settle payment out of $ deposit account
- Pay back £ loan and interest
What are the 5 steps in order to hedge future receipts in $?
- Borrow in $ now
- Convert to £ at spot
- Deposit £ in UK bank, earning interest
- Use receipt to pay back $ loan
- Withdraw £ deposit
What are the 4 steps to calculating the effective forward rate of a money market hedge used to pay in foreign currency?
- Calculate the amount needed to be saved in $ now by discounting the payment amount (X) to today using the US deposit rate
- Translate to £ at the spot rate
- Calculate what our £ loan will grow to at the payment date by using the UK borrowing rate (Y)
- Divide the future payment X by future loan value Y
What are the 4 steps to calculating the effective forward rate of a money market hedge used to receipt in foreign currency?
- Calculate the amount needed to borrow in $ now that will be paid of by receipt amount X, by discounting the receipt amount (X) to today using the US borrowing rate
- Translate to £ at the spot rate
- Calculate what the £ deposit will have grown to at the payment date by using the UK deposit rate (Y)
- Divide the future receipt X by future deposit value Y
What are FX futures?
Standardised traded contracts to buy or sell a set amount of currency at a set rate, at a standard date in the future
What do FX futures result in?
No currency exchange, only a net gain or loss in the currency in which the price is quoted
What are the 3 steps to set up a hedge using FX futures for an expected $ receipt?
- Buy £ futures (as you will want to SELL $ and BUY £)
- Choose the first available futures date after settlement
- Calculate the no. of contracts as $ receipt / contract value x futures price
What are the 3 steps to close out a hedge of using FX futures for an expected $ receipt?
- Close out by selling the same number of contracts
- Receive the net gain/loss: (Sell price - buy price) x no. contracts x contract value
- Convert the $ gain/loss to £ at the spot rate
What are the 3 steps to set up a hedge using FX futures for an expected $ payment?
- Sell £ futures (as you will want to BUY $ and SELL £)
- Choose the first available futures date after settlement
- Calculate the no. of contracts as $ payment / contract value x futures price
What are the 3 steps to close out a hedge of using FX futures for an expected $ payment?
- Close out by buying the same number of contracts
- Receive the net gain/loss: (Buy price - sell price) x no. contracts x contract value
- Convert the $ gain/loss to £ at the spot rate
What are the 2 pros of FX futures?
- Hedge downside risk
- Can close out a futures position at any time (more flexible than forwards)
What are the 4 cons of FX futures?
- Lose upside potential
- Standardised so may over/under hedge
- Basis risk if maturity does not equal transaction date
- You must post margin to the exchange
What is a currency option?
An agreement involving a right, but not an obligation, to buy or sell a certain amount of currency at a stated rate of exchange (exercise price) at some time in the future
What is the main pro of options?
They protect against adverse movements AND allow investors to take upside
What is the main con of options?
You must pay a premium
Based on the underlying currency, $, what is a call option?
The option to buy $ at a set price
Based on the underlying currency, $, what is a put option?
The option to sell $ at a set price
What is the strike price?
The price you end up paying for the currency
What are OTC currency options?
Paying a premium to buy a tailored option, that will result in exchange of currency if exercised, paying a premium in £
What are the 3 steps to set up a hedge using FX OTC option in $ for an expected $ receipt?
- Buy a put option on $, as we will want to sell $ at the receipt date
- Choose a strike price
- Pay the premium in £
What is the outcome of a $ OTC option hedge set up for a $ receipt, if the $ weakens?
We have bought an option to sell $, so as the $ is now weaker we convert at the STRIKE price as we get more money from our option
What is the outcome of a $ OTC option hedge set up for a $ receipt, if the $ strengthens?
We have bought an option to sell $, so as the $ is now stronger we convert at the SPOT rate as we get more from the current rate than we would at our option strike price
What are the 3 steps to set up a hedge using FX OTC option in $ for an expected $ payment?
- Buy a call option on $, as we want to buy $ at the receipt date
- Choose a strike price
- Pay the premium now in £
